<PAGE>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number 1-8692
PACIFIC GATEWAY PROPERTIES, INC.
(Exact name of Registrant as specified in its charter)
NEW YORK 04-2816560
------------------------------- -------------------
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
930 MONTGOMERY STREET, SUITE 400, SAN FRANCISCO, CALIFORNIA 94133
- --------------------------------------------------------------------------------
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (415) 398-4800
- --------------------------------------------------------------------------------
(Former name, former address and former fiscal year, if changed since last
report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes No X
----- -----
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of June 30, 1997:
$1.00 PAR VALUE COMMON STOCK 3,892,596
- ---------------------------- ------------------------------
(Title of Class) (Number of Shares Outstanding)
1
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
INDEX
PAGE NUMBER
-----------
Part I - Financial Information:
Item 1. Consolidated Financial Statements
Condensed Consolidated Balance Sheet as of
June 30, 1997 and December 31, 1996 3
Condensed Consolidated Statement of Income for the
Three and Six Months Ended June 30, 1997
and 1996 4
Condensed Consolidated Statement of Cash Flows for
the Three and Six Months Ended June 30, 1997
and 1996 5
Notes to Condensed Consolidated Financial Statements 6-10
Item 2. Management's Discussion and
Analysis of Financial Condition
and Results of Operations 11-16
Part II - Other Information:
Item 1. Legal Proceedings None
Item 2. Changes in Security None
Item 3. Defaults Upon Senior Securities 16
Item 4. Submission of Matters to a Vote
of Security Holders 16
Item 5. Other Information None
Item 6. Exhibits and Reports on Form 8-K 16
Signatures 17
2
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
CONDENSED CONSOLIDATED BALANCE SHEET (UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
AS OF AS OF
JUNE 30, DECEMBER 31,
1997 1996
-------- ------------
ASSETS
Cash and cash equivalents $ 2,331 $ 2,899
Cash reserved for capital improvements,
acquisitions and debt service 1,909 9,975
Accounts receivable, prepaid taxes and other
current assets 641 1,179
Investment properties 68,687 46,632
Less-accumulated depreciation and provision
for write-down to net realizable value (15,179) (13,835)
-------- --------
Investment properties, net 53,508 32,797
-------- --------
Deferred tax asset 5,683 4,183
Capitalized loan costs, net 906 717
Capitalized lease commissions and rent
concessions, net 873 643
-------- --------
Total assets $ 65,851 $ 52,393
-------- --------
-------- --------
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable, prepaid rent, tenant security
deposits and other current liabilities $ 1,427 $ 1,491
Debt related to investment properties 47,834 33,722
Deferred tax liability 16,512 15,012
-------- --------
Total liabilities 65,773 50,225
-------- --------
STOCKHOLDERS' EQUITY
Common stock $1.00 par value--
Authorized--10,000,000 shares
Issued--4,011,150 shares 4,011 4,011
Paid-in-deficit (10,038) (10,222)
Retained earnings 6,252 8,526
Treasury stock, at cost--118,554 common shares at
June 30, 1997 and December 31, 1996 (2,037) (2,037)
Warrants for common stock 1,890 1,890
-------- --------
Total stockholders' equity 78 2,168
-------- --------
Total liabilities and stockholders' equity $ 65,851 $ 52,393
-------- --------
-------- --------
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
CONDENSED CONSOLIDATED STATEMENT OF INCOME (UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
FOR THE THREE MONTHS FOR THE SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
-------------------- ------------------
1997 1996 1997 1996
------- ------- ------- -------
<S> <C> <C> <C> <C>
INVESTMENT PROPERTIES:
Rental revenues $ 3,557 $ 2,546 $ 6,878 $ 5,720
Operating expenses (1,580) (1,334) (2,853) (2,600)
Interest expense (1,049) (605) (1,900) (1,508)
Depreciation and amortization (793) (634) (1,507) (1,238)
------- ------- ------- -------
Investment properties income (loss) 135 (27) 618 374
General and administrative expenses (280) (462) (700) (858)
Other income, net 64 210 101 214
------- ------- ------- -------
Income (loss) before hotel operations, estimated
property settlement obligation, property
transactions and taxes (81) (279) 19 (270)
Income (loss) from hotel operations 1 192 (93) 1,146
------- ------- ------- -------
Income (loss) before estimated settlement
obligation, property transactions
and taxes (80) (87) (74) 876
Estimated provision for settlement of the
reimbursement obligation (2,200) -- (2,200) --
Gain on sale of real estate assets, net -- 10,900 -- 10,900
------- ------- ------- -------
Income (loss) before taxes (2,280) 10,813 (2,274) 11,776
Income tax provision -- (4,434) -- (4,808)
------- ------- ------- -------
Net income (loss) $(2,280) $ 6,379 $(2,274) $ 6,968
------- ------- ------- -------
------- ------- ------- -------
Income (loss) per share, primary $ (0.50) $ 1.49 $ (0.50) $ 1.67
------- ------- ------- -------
------- ------- ------- -------
Income (loss) per share, fully diluted $ (0.50) $ 1.46 $ (0.50) $ 1.60
------- ------- ------- -------
------- ------- ------- -------
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(IN THOUSANDS)
<TABLE>
<CAPTION>
FOR THE THREE MONTHS FOR THE SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
-------------------- ---------------------
1997 1996 1997 1996
------- -------- -------- --------
<S> <C> <C> <C> <C>
Cash flow from operating activities:
Net income (loss) $(2,280) $ 6,379 $ (2,274) $ 6,968
Non-cash revenues and expenses
included in net income (loss):
Depreciation and amortization 793 634 1,507 1,238
Estimated provision for settlement of the
reimbursement obligation 2,200 -- 2,200 --
Gain on sale of real estate assets, net -- (10,900) -- (10,900)
Change in assets and liabilities:
Accounts receivable, prepaid taxes and other
current assets (37) (337) 538 (250)
Accounts payable and other current liabilities (443) (666) (64) (992)
Current tax liability -- 626 -- 626
Deferred taxes -- 3,625 -- 3,999
------- -------- -------- --------
NET CASH GENERATED BY (USED IN) OPERATING
ACTIVITIES 233 (639) 1,907 689
------- -------- -------- --------
Cash flow from investing activities:
Additions to investment properties,
capitalized loan costs, capitalized
lease commissions and rent concessions (809) (875) (1,459) (1,093)
Proceeds from sale of property, net -- 19,122 -- 19,122
Acquisition of investment properties -- -- (10,975) --
------- -------- -------- --------
NET CASH GENERATED BY (USED IN) INVESTING
ACTIVITIES (809) 18,247 (12,434) 18,029
------- -------- -------- --------
Cash flow from financing activities:
Borrowings on debt related to investment
properties -- -- 2,112 --
Payments on debt related to investment properties (212) (388) (403) (1,062)
Mortgages satisfied in connection with
property dispositions -- (15,224) -- (15,224)
Proceeds from shareholder short-swing sale 184 -- 184 --
(Increase) decrease in cash reserved for
capital improvements, acquisitions,
and debt service, net (127) (29) 8,066 138
------- -------- -------- --------
NET CASH GENERATED BY (USED IN) FINANCING
ACTIVITIES (155) (15,641) 9,959 (16,148)
------- -------- -------- --------
Increase (decrease) in cash and cash equivalents (731) 1,967 (568) 2,570
Balance at beginning of period 3,062 779 2,899 176
------- -------- -------- --------
Balance at end of period $ 2,331 $ 2,746 $ 2,331 $ 2,746
------- -------- -------- --------
------- -------- -------- --------
Supplementary disclosures:
Cash paid for interest $ 972 $ 811 $ 1,900 $ 1,885
------- -------- -------- --------
------- -------- -------- --------
Cash paid for taxes $ -- $ 410 $ -- $ 410
------- -------- -------- --------
------- -------- -------- --------
Non-cash transaction--portion of
acquisition of investment properties
funded by assumption of mortgage debt $ -- $ -- $ 10,203 $ --
------- -------- -------- --------
------- -------- -------- --------
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE QUARTER AND SIX MONTHS ENDED JUNE 30, 1997
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying unaudited condensed consolidated financial statements
should be read in conjunction with the Registrant's 1996 Form 10-K and Form
10-Q for the quarter and six months ended June 30, 1996. These statements
have been prepared in accordance with the instructions of the Securities and
Exchange Commission Form 10-Q and do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements.
In the opinion of the Registrant, all material adjustments of a normal
recurring nature considered necessary for a fair presentation of results of
operations for the interim periods have been included. The results of
consolidated operations for the three and six months ended June 30, 1997 are
not necessarily indicative of the results that may be expected for the year
ending December 31, 1997.
RECLASSIFICATIONS
Certain prior year amounts have been reclassified to be consistent with
current year classifications.
ESTIMATES AND ASSUMPTIONS
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities,
disclosure of contingent assets and liabilities at the date of the financial
statements, and the reported amounts of revenues and expenses during the
reporting period. Actual results will differ from those estimates.
2. RINCON CENTER ASSOCIATES PARTNERSHIP (RCA)--SAN FRANCISCO, CALIFORNIA
The Registrant owns general (non-managing) and limited partnership
interests in RCA totaling approximately 22.8% and, subject to the funding
agreement entered into with RCA's managing general partner, Perini Land &
Development Company (a wholly owned subsidiary of Perini Corporation),
discussed below, is responsible for 20% of cash requirements in excess of
available financing. The Registrant's minority, general (non-managing) and
limited partnership interests in RCA represent significant potential
financial exposure. This exposure includes and may not be limited to the
potential tax liability associated with the Registrant's negative tax basis,
the joint and several guarantees and letter-of-credit provided by the
Registrant to the mortgage lender on Rincon Center Phase Two and the master
lessor on Rincon Center Phase One, and the potential tax liability that would
exist from the cancellation of debt in connection with a possible debt
restructuring. Except for the estimated provision for settlement of the
reimbursement obligation and income tax effect related to the tax that would
result from any gain recognized from the Registrant's negative tax basis in
its partnership interest, the accompanying financial statements do not
include any adjustments for these uncertainties.
RCA sold Rincon Center Phase One to Chrysler MacNally Corporation
(Chrysler) in June 1988; subsequently, RCA leased the property back under a
master lease which is treated as an operating lease for financial reporting
purposes. In July 1993, Chrysler completed a
6
<PAGE>
refinancing of Rincon Center Phase One. The maturity date of this debt is
July 1, 1998. Payments under the master lease agreement may be adjusted to
reflect adjustments in the rate of interest payable by Chrysler on the Rincon
Center Phase One debt. The master lease also permits Chrysler to put the
property back to RCA at stipulated prices beginning January 1998 if long-term
financing meeting certain conditions is not obtained. RCA intends to try to
obtain financing meeting the condition of the master lease prior to January
1998. On June 30, 1997, RCA filed a lawsuit against Chrysler in Superior
Court in the State of California, County of San Francisco. The lawsuit's
primary cause of action alleges that Chrysler has breached the master lease
and a certain letter agreement because the rent payments due from RCA after
the 1993 refinancing of Rincon Center Phase I, resulted in an increase in
Chrysler's after tax rate of return from rent payments. The lawsuit states
that such excessive rent recalculations directly contravene both the letter
and the spirit of the master lease.
In September 1993, RCA completed a refinancing of Rincon Center Phase Two
with its existing lender. A portion of the security for the refinanced loan
was a $3.65 million letter-of-credit issued by a bank (the Issuing Bank) on
behalf of the Registrant in favor of the refinancing lender. The
reimbursement obligation of the Registrant to the Issuing Bank is full
recourse to the Registrant and is secured by the Registrant's 410 First
Avenue property located in Needham, Massachusetts. This property has a net
book value of approximately $2.2 million at June 30, 1997. The
letter-of-credit for $3.65 million was drawn by the refinancing lender prior
to its expiration date of June 23, 1997. The refinancing lender is currently
holding the $3.65 million in a separate restricted account on behalf of RCA
and has not applied said funds to any outstanding debt of RCA. The
Registrant and the Issuing Bank are currently in discussions to reach a
mutually acceptable resolution since the letter-of-credit was drawn.
Alternative resolutions may include, among other things, (i) arrangement of a
substitute letter-of-credit from another bank, which would be acceptable to
the refinancing lender, which in turn would result in a return of the funds
drawn by the refinancing lender to the Issuing Bank, (ii) repayment by the
Registrant of the reimbursement obligation at a discount, or (iii)
foreclosure by the Issuing Bank on the 410 First Avenue property. The
Issuing Bank has made a demand on the Registrant to reimburse them for the
$3.65 million drawn on the letter-of-credit and has also notified the
Registrant it is in default with respect to the reimbursement obligation. In
the event that the Registrant and the Issuing Bank do not agree on a mutually
acceptable resolution on the restructuring or pay off of this debt, the
Issuing Bank may commence foreclosure proceedings against the Needham,
Massachusetts property. In the event of a foreclosure of the Needham,
Massachusetts property, the Issuing Bank may also seek to assert a deficiency
claim against the Registrant for any alleged difference between the value of
the foreclosed property and the $3.65 million drawn on the letter-of-credit.
The Registrant would vigorously defend any such deficiency claim. Since any
assets of the Registrant which are applied to the reimbursement obligation
would constitute additional investment in RCA, which the Registrant considers
of no value, the net book value of such assets would be written off and
charged to the earnings of the Registrant when said assets were applied to
the reimbursement obligation. In accordance with generally accepted
accounting principles, effective June 30, 1997, the Registrant recorded an
"estimated provision for settlement of reimbursement obligation" in the
amount of $2.2 million to provide for the ultimate settlement of the
reimbursement obligation. The accrued amount is equal to the net book value
of the Needham, Massachusetts property that serves as collateral for the
reimbursement obligation, resulting in an effective discount of the $3.65
million face value of the reimbursement obligation. Any difference between
the estimated settlement of reimbursement obligation and the amount
ultimately settled upon will be charged or credited to the Registrant's
operations as such
7
<PAGE>
difference becomes determinable. Management can provide no assurances as to
the ultimate settlement amount or method (and the timing thereof) relating to
the reimbursement obligation.
In 1993, the Registrant entered into an agreement with RCA's managing
general partner whereby such managing general partner agreed to advance funds
to RCA on behalf of the Registrant on an unsecured non-recourse basis,
subject to interest at prime plus 2% and certain annual fees (principal,
unpaid interest and fees are collectively referred to as the RCA Advances).
This agreement does not reduce the level of the Registrant's general and
limited partner interest in RCA. The RCA Advances are only required to be
repaid from the Registrant's share of future distributions from RCA, if any.
During the first six months of 1997 and 1996, RCA incurred net losses of
approximately $9,958,000 and $7,139,000, respectively. The RCA Advances
amount to approximately $5,243,000 at June 30, 1997 and as noted above, are
not recorded on the Registrant's financial statements since (i) the RCA
Advances are only required to be repaid from the Registrant's share of future
distributions from RCA, if any, (ii) the Registrant has no intention or legal
obligation to repay the RCA Advances other than from its share of
distributions from RCA, if any, and (iii) the Registrant does not anticipate
any material cash distributions by RCA in the foreseeable future.
During 1997, the Registrant has asserted certain claims against RCA for
payment to the Registrant by RCA for leasing services provided to RCA by the
Registrant during 1996. The Registrant has not accrued for such claims
pending resolution of this matter with RCA's managing general partner.
Summary unaudited financial statement data for RCA is as follows (in
thousands):
AS OF JUNE 30, DECEMBER 31,
1997 1996
--------- ------------
Investment properties, net $ 100,548 $110,495
Other assets 30,785 21,042
--------- ------------
$ 131,333 $131,537
--------- ------------
--------- ------------
Debt $ 54,862 $ 56,012
Amounts due to partners 171,052 158,156
Other liabilities 10,722 12,703
Partners' deficit (105,303) (95,334)
--------- ------------
$ 131,333 $131,537
--------- ------------
--------- ------------
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------- -------------------
1997 1996 1997 1996
------- ------- ------- -------
Revenue $ 3,719 $ 5,483 $ 7,727 $10,824
Expenses:
Operating and lease expenses 4,608 3,289 9,015 6,680
Interest expense 3,759 4,682 7,239 9,394
Depreciation expense 720 945 1,431 1,889
------- ------- ------- -------
Net loss $(5,368) $(3,433) $(9,958) $(7,139)
------- ------- ------- -------
------- ------- ------- -------
8
<PAGE>
In 1996, the Registrant ceased recording any activity related to its
interest in RCA and has written down its equity investment in and loans to RCA
to zero.
3. PER SHARE DATA
Per share data is based on the weighted average number of the
Registrant's common shares and common share equivalents outstanding.
Outstanding warrants and stock options enter into the common shares
outstanding using the Treasury Stock Method. The weighted average number of
common shares and common share equivalents outstanding for the three months
and six months ended June 30, 1997 and 1996, are as follows:
FOR THE THREE MONTHS FOR THE SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
1997 1996 1997 1996
--------- --------- --------- ---------
Primary 4,564,800 4,284,697 4,476,107 4,166,097
--------- --------- --------- ---------
--------- --------- --------- ---------
Fully diluted 4,564,800 4,367,059 4,502,204 4,367,059
--------- --------- --------- ---------
--------- --------- --------- ---------
In March 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standard No. 128, Earnings Per Share (SFAS No. 128).
SFAS No. 128 requires the disclosure of basic earnings per share and modifies
existing guidance for computing diluted earnings per share. Under the new
standard, basic earnings per share is computed as earnings divided by
weighted average shares, excluding the dilutive effects of stock options and
other potentially dilutive securities. The effective date of SFAS No. 128 is
December 15, 1997, and early adoption is not permitted. The Registrant
intends to adopt provisions of SFAS No. 128 during the quarter and year ended
December 31, 1997. Had the provisions of SFAS No. 128 been applied to the
Registrant's results of operations for the three months ended June 30, 1997
and 1996, the Registrant's basic earnings per share would have been ($0.57)
and $1.59 per share, respectively, and its diluted earnings per share would
have been ($0.52) and $1.47 per share, respectively. Had the provisions of
SFAS No. 128 been applied to the Registrant's results of operations for the
six months ended June 30, 1997 and 1996, the Registrant's basic earnings per
share would have been ($0.57) and $1.74 per share, respectively, and its
diluted earnings per share would have been ($0.52) and $1.66 per share,
respectively.
4. ACQUISITION OF INVESTMENT PROPERTY
On January 17, 1997, the Registrant purchased two properties to complete
a tax deferred exchange in accordance with Section 1031 of the Internal
Revenue Code, in connection with the December 1996 sale of the Radisson
Suites Hotel. The first acquisition was West Valley Executive Park, a
multi-tenant, six building, 165,000 square foot campus style office park in
San Jose, California, that was acquired for $17,500,000. In connection with
the West Valley Executive Park acquisition, the Registrant assumed
approximately $10,200,000 in mortgage debt from Sun Life Assurance Company of
Canada (U.S.). The loan is amortized over twenty years at a fixed annual
interest rate of 9.125% and matures on June 30, 2005. The debt continues to
be assumable and is subject to a prepayment penalty if paid off prior to
maturity. The second acquisition was a multi-tenant, 23,000 square foot, six
story steel frame office building located at 930 Montgomery Street, San
Francisco, California, for $3,250,000. In connection with the 930 Montgomery
Street acquisition, the
9
<PAGE>
Registrant obtained $2,112,500 in mortgage debt from Redwood Bank. The loan
is amortized over twenty-five years at a floating interest rate of 3% over
the one year treasury bond rate, adjustable every six months, and matures on
February 1, 2002. The Redwood Bank debt can be prepaid at any time without a
penalty.
The following unaudited pro-forma information reflects adjustments to the
Registrant's historical results from these acquisitions and certain other
transactions as if they had occurred on January 1, 1996 (in thousands, except
share amounts):
<TABLE>
<CAPTION>
FOR THE THREE FOR THE SIX
MONTHS ENDED MONTHS ENDED
JUNE 30, JUNE 30,
1997 1996 1997 1996
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Revenues $3,557 $3,364 $7,023 $7,356
--------- --------- --------- ---------
--------- --------- --------- ---------
Income (loss) before hotel
operations, estimated
settlement obligation,
property transactions and
taxes $ (81) $ (183) $ 68 $ (78)
--------- --------- --------- ---------
--------- --------- --------- ---------
Income (loss) before hotel
operations, estimated
settlement obligation,
property transactions and
taxes per common share --
Primary $(0.02) $(0.04) $ 0.02 $(0.02)
--------- --------- --------- ---------
--------- --------- --------- ---------
Fully diluted $(0.02) $(0.04) $ 0.02 $(0.02)
--------- --------- --------- ---------
--------- --------- --------- ---------
Weighted average common shares
outstanding --
Primary 4,564,800 4,284,697 4,476,107 4,166,097
--------- --------- --------- ---------
--------- --------- --------- ---------
Fully diluted 4,564,800 4,367,059 4,502,204 4,367,059
--------- --------- --------- ---------
--------- --------- --------- ---------
</TABLE>
5. PAID-IN-DEFICIT
During the quarter ended June 30, 1997, the Registrant received
approximately $184,000 in cash from two shareholders as a result of their
compliance with the Securities Exchange Act's requirement that profits from
the sale of certain securities of a company that were held less than six
months by certain officers, directors and principal stockholders must be
returned to the Registrant. In accordance with generally accepted accounting
principles, the Registrant recorded such proceeds as a credit to the
Registrant's paid-in-deficit.
10
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
INTRODUCTION
The Registrant is a New York corporation formed in 1984 for the purpose
of investing and managing income producing real estate. The Registrant's
overall business plan has been to assemble a substantial portfolio of income
producing properties. The Registrant historically focused its property
acquisitions in four markets: Northern California, Arizona, Florida and
Massachusetts. The Registrant's long-term objectives continue to be
maximizing net cash flow from operations and achieving growth through
appreciation of asset values. The current strategic plan of the Registrant
is to focus on real estate investments on the West Coast with a specific
emphasis on the San Francisco Bay Area. The current investment emphasis is
on commercial properties which require aggressive management and leasing in
order to maximize their potential. This strategy is influenced by the
following factors: (1) the Registrant's current property portfolio is
concentrated on the West Coast; and (2) the Registrant believes that
geographic concentration will enhance operational efficiencies.
The following discussion should be read in conjunction with the
Registrant's Form 10-K for 1996, quarterly report on Form 10-Q for the
quarter and six months ended June 30, 1996, and in conjunction with the
Condensed Consolidated Balance Sheet, Statement of Operations and Cash Flows
and the notes thereto. Unless otherwise defined in this report, or unless
the context otherwise requires, the capitalized words or phrases used in this
section either (i) describe accounting terms that are used as line items in
such financial statements, or (ii) have the meanings ascribed to them in such
financial statements and the notes thereto.
FINANCIAL CONDITION
CAPITAL IMPROVEMENTS, TENANT IMPROVEMENTS AND OTHER DEFERRED COSTS --
During the three and six months ended June 30, 1997, there were additions to
investment properties amounting to approximately $809,000 and $1,459,000,
respectively, for tenant improvements, capital improvements and other
deferred costs which includes leasing commissions. The Registrant
anticipates further additions to investment properties of approximately
$2,900,000 during the remainder of 1997.
FINANCING -- Approximately $212,000 and $403,000 of debt principal was
repaid in the three and six months ended June 30, 1997, respectively, as
scheduled debt amortization. In connection with the acquisitions of
investment properties during the six months ended June 30, 1997, the
Registrant assumed and borrowed mortgage notes totaling approximately
$12,315,000. Accordingly, at June 30, 1997, the Registrant had fixed rate
mortgage debt of approximately $43.5 million bearing interest at a weighted
average rate of 8.49%, one floating rate mortgage of approximately $2.1
million bearing interest at a rate of 8.63%, and a secured estimated
settlement obligation recorded at $2,200,000, as more fully discussed in Note 2
of the Registrant's unaudited condensed consolidated financial statements.
MATERIAL CHANGES IN RESULTS OF OPERATIONS
INVESTMENT PROPERTIES -- During the first six months of 1997, the income
from investment properties was $618,000 compared to income of $374,000 during
the first six
11
<PAGE>
months of 1996. During the second quarter of 1997 the income from investment
properties was $135,000 compared to a loss of $27,000 for the second quarter
of 1996. Interest expense increased from $1,508,000 during the first six
months of 1996 to $1,900,000 during the first six months of 1997, primarily
as a result of the debt associated with the properties acquired in January
1997. Depreciation and amortization expense increased as a result of
commencing depreciation of expenditures capitalized during 1996 and early
1997 relating to the Registrant's leasing activities and capital improvement
projects, and new investment property acquisitions completed in the first
quarter of 1997.
The following table identifies the impact of certain investment property
dispositions, acquisitions and properties owned in the three and six months
ended June 30, 1997 and 1996, respectively (in thousands):
<TABLE>
<CAPTION>
FOR THE THREE FOR THE SIX
MONTHS ENDED MONTHS ENDED
JUNE 30, JUNE 30,
-------------------- ----------------
1997 1996 1997 1996
-------- ------- ------- -------
<S> <C> <C> <C> <C>
INVESTMENT PROPERTIES OWNED IN
1997 AND 1996:
Rental revenue $ 2,697 $ 2,541 $ 5,287 $ 5,014
Operating expense (1,231) (1,473) (2,265) (2,481)
Interest expense (695) (595) (1,394) (1,239)
Depreciation expense (661) (634) (1,292) (1,238)
-------- ------- ------- -------
110 (161) 336 56
-------- ------- ------- -------
INVESTMENT PROPERTIES ACQUIRED IN
JANUARY 1997:
Rental revenue 860 -- 1,591 --
Operating expense (349) -- (588) --
Interest expense (354) -- (506) --
Depreciation expense (132) -- (215) --
-------- ------- ------- -------
25 282 --
-------- ------- ------- -------
INVESTMENT PROPERTY SOLD IN APRIL 1996:
Rental revenue -- 5 -- 706
Operating expense -- 139 -- (119)
Interest expense -- (10) -- (269)
Depreciation expense -- 0 -- --
-------- ------- ------- -------
-- 134 -- 318
-------- ------- ------- -------
TOTAL INVESTMENT PROPERTIES:
Rental revenue 3,557 2,546 6,878 5,720
Operating expense (1,580) (1,334) (2,853) (2,600)
Interest expense (1,049) (605) (1,900) (1,508)
Depreciation expense (793) (634) (1,507) (1,238)
-------- ------- ------- -------
TOTAL INVESTMENT PROPERTIES INCOME
(LOSS) $ 135 $ (27) $ 618 $ 374
-------- ------- ------- -------
-------- ------- ------- -------
</TABLE>
12
<PAGE>
GENERAL AND ADMINISTRATIVE EXPENSES -- General and administrative
expenses in the first six months of 1997 amounted to $700,000 compared to
$858,000 for the first six months of 1996. General and administrative
expenses for the second quarter of 1997 and 1996 were $280,000 and $462,000,
respectively. The decrease is primarily attributable to a decrease in
professional services and personnel costs including severance to a former
executive.
OTHER INCOME, NET -- Other income, net, consisting primarily of interest
income, was $101,000 and $64,000 during the first six months and second
quarter of 1997, respectively. Other income, net, consisting primarily of
business advisory fees and income from the sale of vacant land in Colorado
was $214,000 and $210,000 during the first six months and second quarter of
1996, respectively.
HOTEL PROPERTY -- The Registrant sold its hotel property in December 1996
and, accordingly, a comparison of the operations from the first six months
and second quarter of 1996 to the first six months and second quarter of 1997
is not meaningful.
ESTIMATED PROVISION FOR SETTLEMENT OF THE REIMBURSEMENT OBLIGATION --
Effective June 30, 1997, the Registrant recorded an estimated provision of
$2.2 million for the ultimate settlement of the letter of credit
reimbursement obligation, as more fully discussed in Note 2 to the
Registrant's unaudited condensed consolidated financial statements.
GAIN ON SALE OF REAL ESTATE ASSETS, NET -- In April 1996, the Registrant
sold the Village Commons Shopping Center, located in West Palm Beach,
Florida, to an unrelated party and realized a gain of $10,900,000.
INCOME TAX PROVISION -- A tax provision is recorded in connection with
the net income for the three and six months ended June 30, 1996, of
$4,434,000 and $4,808,000, respectively, in accordance with Statement of
Financial Accounting Standards No. 109. No provision for income taxes has
been recorded for the three and six months ended June 30, 1997.
LIQUIDITY AND CAPITAL RESOURCES
REGULATION AND SUPERVISION
Many jurisdictions have adopted laws and regulation relating to the
ownership of real estate. Compliance with these requirements from time to
time may require capital expenditures by the Registrant (for example,
expenditures necessary in order to comply with the Americans with
Disabilities Act or changes in local building or other codes). In addition,
the Registrant may from time to time have to expend capital for environmental
control facilities. While the ownership of real estate may entail
environmental risks and liabilities to the owner, the Registrant's management
is sensitive to environmental issues and is not currently aware of and does
not expect any material effects on current or future capital expenditures,
earnings or competitive position resulting from compliance with present
federal, state or local environmental control provisions.
DISCUSSION OF KNOWN TRENDS, EVENTS AND UNCERTAINTIES
The economic climate for commercial real estate has begun to show signs
that rental rates and property values have stabilized and in selected markets
have actually improved. Notwithstanding a stabilizing real estate market,
tenants may or may not continue to renew leases as they expire or may renew
on less favorable terms. Conditions differ in each market in which the
Registrant's properties are located. Because of the continuing uncertainty
of
13
<PAGE>
future economic developments in each market, the impact these developments
will have on the Registrant's future cash flow and results of operations is
uncertain.
Inflation, inflationary expectations and their effect on interest rates
may affect the Registrant in the future by changing the underlying value of
the Registrant's real estate or by impacting the costs of financing the
Registrant's operations.
LIQUIDITY AND CAPITAL RESOURCES
The bulk of the Registrant's resources are committed to relatively
non-liquid real estate assets. These assets, due to their value and cash
flow, have provided the Registrant with an ability to generate capital as
required, both internally and externally, through asset-based financings. In
addition, since 1992, assets or portions thereof were sold to provide further
liquidity.
The Registrant has taken several actions to generate and conserve cash,
and continues to review and analyze alternative actions. At the same time,
the Registrant is seeking to retain value and identify future opportunities
for investment. At June 30, 1997, the Registrant had approximately $2.3
million of unrestricted cash, investment properties with a net book value of
approximately $53.5 million, total non-recourse mortgage debt and secured
estimated settlement obligation of approximately $47.8 million and
stockholders' equity of approximately $78,000. At June 30, 1997, the
Registrant had approximately $1.9 million of restricted cash. Given the
Registrant's desire to increase its liquidity, the Registrant has actively
pursued the sale of selected real estate assets in the past, has restructured
and refinanced its mortgage debt, and has entered into an agreement with the
managing general partner of RCA to limit the Registrant's cash obligations to
RCA. The Registrant continues to evaluate various alternatives to improve
its liquidity through debt refinancing and the sale of properties which do
not fit within its long term strategy. Funds raised in the preceding fashion
would be used for tenant improvements and other capital requirements, certain
mandatory debt reductions, and possible new investments.
Scheduled principal maturities on the above described debt during the
twelve month period ending June 30, 1998, will amount to approximately
$904,000.
The Registrant is also obligated to fund reserves for building, tenant
improvements and leasing commissions in connection with its mortgage loans on
Walnut Creek Executive Park, North Tuscon Business Center and South Bay
Office Tower. Scheduled funding under the various loan agreements during the
twelve month period ending June 30, 1998, will amount to approximately
$575,000.
As further discussed in Note 5 of the Registrant's unaudited condensed
consolidated financial statements, during the quarter ended June 30, 1997,
the Registrant received approximately $184,000 in cash from a shareholder as
a return of profit from the sale of certain securities. This amount has been
recorded as a credit to the Registrant's paid-in-deficit.
The Registrant's Massachusetts property is pledged as collateral for a
$3.65 million letter-of-credit that was drawn as of June 30, 1997. As
discussed in Note 2 of the Registrant's unaudited condensed consolidated
financial statements, the Registrant and the Issuing Bank are currently in
discussions to reach a mutually acceptable resolution since the
letter-of-credit was drawn. The Issuing Bank had made a demand on the
Registrant to
14
<PAGE>
reimburse them for the $3.65 million drawn on the letter-of-credit and has
also notified the Registrant it is in default with respect to the
reimbursement obligation. In the event that the Registrant and the Issuing
Bank do not agree on a mutually acceptable resolution on the restructuring or
pay off of this debt, the Issuing Bank may commence foreclosure proceedings
against the Massachusetts property. If the Issuing Bank completes a
foreclosure on the Massachusetts property, the Registrant will eliminate
$3.65 million in secured debt on a property that is producing approximately
$240,000 in annual cash flow. In the event of a foreclosure of the
Massachusetts property, the Issuing Bank may also seek to assert a deficiency
claim against the Registrant for any alleged difference between the value of
the foreclosed property and the $3.65 million drawn on the letter-of-credit.
The Registrant would vigorously defend any such claim. In accordance with
generally accepted accounting principles, effective June 30, 1997, the
Registrant recorded an "estimated provision for settlement of reimbursement
obligation" in the amount of $2.2 million to provide for the ultimate
settlement of the reimbursement obligation. The accrued amount is equal to
the net book value of the Needham, Massachusetts property that serves as
collateral for the reimbursement obligation, resulting in an effective
discount of the $3.65 million face value of the reimbursement obligation.
Any difference between that estimated settlement of reimbursement obligation
and the amount ultimately settled upon will be charged or credited to the
Registrant's operations as such difference becomes determinable. Management
can provide no assurances as to the ultimate settlement amount or method (and
the timing thereof) relating to the reimbursement obligation.
The Registrant's minority, non-managing partnership interest in RCA
represents significant potential financial exposure. This exposure includes,
and may not be limited to, the potential tax liability associated with the
Registrant's negative tax basis, the joint and several guarantees and
letter-of-credit provided by the Registrant to the mortgage lender on Rincon
Center Phase Two and the master lessor on Rincon Center Phase One, and the
potential tax liability that would exist from the cancellation of debt in
connection with a possible debt restructuring. Additionally, RCA's managing
general partner agreed to advance funds to RCA on behalf of the Registrant on
an unsecured non-recourse basis, subject to interest at prime plus 2% and
certain annual fees (principal, unpaid interest, and fees are collectively
referred to as the RCA Advances). The RCA Advances amount to approximately
$5,243,000 at June 30, 1997, and are not recorded by the Registrant since (i)
the RCA Advances are only required to be repaid from the Registrant's share
of future distributions from RCA, if any, (ii) the Registrant has no
intention or legal obligation to repay the RCA Advances other than from its
share of distributions from RCA, if any, and (iii) the Registrant does not
anticipate any material cash distributions by RCA in the foreseeable future.
Except as described above, at June 30, 1997, the Registrant has no
contractual commitments for any material capital expenditures over the next
twelve months or beyond that are not expected to be funded from the cash
restricted for capital improvements, acquisitions and debt service or future
cash flow generated by operating activities. Ongoing repair and maintenance
expenditures are expected to be funded from cash flow generated by operating
activities. Future tenant improvements and leasing commissions will be
funded, in part, from the restricted cash described above, cash flow
generated by operating activities and funds generated from future debt
refinancings or property sales, if any.
The Registrant continued to experience more stabilized operating results in
its wholly owned properties during the first and second quarters of 1997, and
except for RCA, expects this trend to continue. In addition, the completion of
certain leasing transactions has
15
<PAGE>
continued to reduce the level of vacancy in the Registrant's portfolio;
however, the Registrant is continuing to aggressively pursue new leases on
currently available space and renew existing leases as they expire.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
As more fully described in Note 2 of the Registrant's unaudited condensed
consolidated financial statements, the Registrant has not reimbursed the
Issuing Bank of a letter of credit issued on behalf of the Registrant for
the $3,650,000 drawn.
ITEM 4. SUBMISSION OF MATTER TO A VOTE OF SECURITY HOLDERS
A Special in Lieu of Annual Meeting ("Annual Meeting") of Shareholders of
the Registrant was held on July 21, 1997. At the Annual Meeting, the
Shareholders elected six incumbent Directors and two new Directors. At the
Annual Meeting, 3,289,878 shares of a total of 3,892,596 shares were
represented; 3,266,438 shares voted in favor of all Nominees for Director.
The following sets forth the results of the vote for each Nominee for
Director:
TOTAL VOTE FOR TOTAL VOTE WITHHELD
EACH DIRECTOR EACH DIRECTOR
-------------- -------------------
S.A. Calabrese 3,301,122 10,892
M.D. Grossi 3,301,338 10,676
L.B. Helzel 3,301,338 10,676
M.A. Jacobs 3,288,374 23,640
C.L. Jarratt 3,301,038 10,976
R.V. Marino 3,301,122 10,892
R.M. Osborne 3,301,038 10,976
M.S. Roher 3,301,338 10,676
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibits:
No. Description
--- -----------
27 Financial Data Schedule
16
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
PACIFIC GATEWAY PROPERTIES, INC.
-------------------------------------
Registrant
Date: August 14, 1997 /s/ Raymond V. Marino
--------------- -------------------------------------
Raymond V. Marino
President and Chief Executive Officer
Date: August 14, 1997 /s/ Melanie L. Adkins
--------------- -------------------------------------
Controller - Management Company
(Principal Accounting Officer)
Date: August 14, 1997 /s/ George S. Mercado
--------------- -------------------------------------
Controller - Corporate
(Principal Accounting Officer)
17
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> JUN-30-1997
<CASH> 4,240
<SECURITIES> 0
<RECEIVABLES> 351
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 4,881
<PP&E> 68,687
<DEPRECIATION> 15,179
<TOTAL-ASSETS> 65,851
<CURRENT-LIABILITIES> 1,427
<BONDS> 47,834
0
0
<COMMON> 4,011
<OTHER-SE> (3,933)
<TOTAL-LIABILITY-AND-EQUITY> 65,851
<SALES> 0
<TOTAL-REVENUES> 6,979
<CGS> 0
<TOTAL-COSTS> 4,360
<OTHER-EXPENSES> 93
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 1,900
<INCOME-PRETAX> (74)
<INCOME-TAX> 0
<INCOME-CONTINUING> 74
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (2,274)
<EPS-PRIMARY> (0.50)
<EPS-DILUTED> (0.50)
</TABLE>
